Greenspan Says “Who Could Have Known?”

That’s right, the former Maestro told Congress last week when asked about the meltdown of the housing bubble and the resulting financial crisis: “we're not smart enough as people. We just cannot see events that far in advance."

Unfortunately, this sentence is even worse in context. Greenspan told the committee about the brilliant economists on staff at the Federal Reserve Board. His point was that if this group could not see the housing bubble, and the risks it posed to the economy, then it was not humanly possible to see it.

The reality is that it was possible – in fact, easy – to recognize the housing bubble as early as the summer of 2002. House prices nationwide had substantially outpaced inflation in the years since 1996 (coinciding with the stock bubble) after just tracking the rate of inflation for the prior hundred years. There was nothing in the fundamentals of supply or demand that could explain this run-up.

Furthermore, there was no corresponding increase in rents. Since people always have the choice to buy or rent, house sale prices and rents should rise and fall together over time, although not necessarily at the exact same pace. In the years since 1996, rents had only modestly outpaced inflation. And they had begun dropping in real terms by 2002. This was not consistent with house prices being driven by fundamentals.

It was also easy to see that the collapse of the housing bubble would cause enormous damage to the economy. Housing itself accounted for more than 6 percent of GDP at the peak of the boom in 2006. Today it accounts for just over 3 percent.

More importantly, housing wealth provided the base for the consumption boom of this period. Research from the Federal Reserve Board and elsewhere shows that annual consumption is increased by 5 to 7 cents for each dollar of housing wealth. This means that the collapse of a bubble that eventually grew to $8 trillion would lead to a reduction in annual consumption on the order of $400 billion to $560 billion (2.6 percent to 3.7 percent of GDP).

In addition, housing is a highly leveraged asset. In normal times, buyers typically borrow 80-90 percent of the purchase price. Of course housing became much more highly leveraged during the bubble with many borrowers putting zero down.

The heavy leverage in the housing market meant that it was inconceivable that a collapse of the housing bubble would not lead to serious consequences for the banking industry. I first warned that the collapse of the bubble would imperil the survival of Fannie Mae and Freddie Mac in September of 2002.

Greenspan would have been correct if he said that we are not smart enough as human beings to know when the bubble would finally burst. I did not expect the bubble to last as long as it did.

Of course I did not bet on there being such a vast reservoir of foolish investors, not only in the United States but also in Asia and Europe, willing to buy garbage mortgages buried in complex derivative instruments. I also didn’t imagine the Fed and other regulatory agencies would ever be so completely out to lunch in policing mortgage issuance and the practices of the investment banks.

But the basic story – that there was a housing bubble that would burst, and that it would cause enormous damage to the economy – was completely knowable to any competent economist long ago. The failure of the economists at the Fed, as well as the vast majority of the economists elsewhere, to see the housing bubble and to recognize the damage that would be caused by its collapse is a testament to the failure of the profession.

Greenspan’s claim that the crisis was not foreseeable is a cover-up for a profession that has badly failed the public. If factory workers or custodians had failed so miserably in their jobs, they would quickly find themselves unemployed.

Remarkably, in economics, the people responsible for this easily preventable disaster are suffering no negative consequences and in fact are still the ones designing the nation’s economic policies. Economists believe that if workers are not held accountable for their performance, then they will not do good work. If economists are not held accountable for their performance, then we should not expect good economic policy.

Contrary to what Greenspan told Congress, “we” are smart enough as people to see asset bubbles like the housing bubble. If his “we” are not smart enough, as he claims, then the current group of economic policy makers must be replaced with people qualified to do the job.